Definition
A Credit Default Swap (CDS) is a financial derivative that serves as a risk management tool to hedge against the default risk of debt securities or other credit events. In its most basic form, it is a contract where one party, known as the protection buyer, periodically makes fixed payments to another party, known as the protection seller. In return, the protection seller agrees to compensate the protection buyer if a third party, known as the reference entity, defaults or undergoes a specified credit event.
Key Components:
- Protection Buyer: Pays periodic premiums to hedge against the risk of default by the reference entity.
- Protection Seller: Receives periodic premiums and compensates the protection buyer upon default.
- Reference Entity: The issuer of the underlying debt (typically a bond or loan) which is the subject of the CDS contract.
- Credit Event: An event of default such as a failure to pay, restructuring, or bankruptcy.
Differences from Insurance:
- The CDS protection buyer does not need to have an insurable interest in the reference entity.
- The buyer can take a CDS purely for speculative reasons, without holding the underlying asset or sustaining an actual loss.
Examples
Example 1: Bond Protection
A bondholder purchases a CDS to protect against the default of Company XYZ’s bond. If XYZ defaults, the CDS seller compensates the bondholder according to the terms of the CDS contract.
Example 2: Speculative Use
An investor expects a company to default and buys a CDS on that company’s bond despite not holding the bond. The investor profits if the company defaults.
Frequently Asked Questions (FAQs)
Q1: What is the primary function of a CDS? A: The primary function of a CDS is to transfer the credit risk of the reference entity’s debt to the protection seller.
Q2: Can a CDS be used speculatively? A: Yes, a CDS can be used speculatively, allowing investors to bet on the creditworthiness of an entity without owning the underlying debt.
Q3: How is a credit event defined in a CDS contract? A: A credit event may include default on debt payments, bankruptcy, or restructuring of debt obligations.
Q4: How do CDS pricing and premiums work? A: The premium, often referred to as the CDS spread, is determined based on the credit risk of the reference entity. Higher risk leads to higher premiums.
Q5: What happens if the reference entity does not default? A: If the reference entity does not default during the CDS contract period, the protection buyer continues to make premium payments, and the seller keeps the premiums with no further obligations.
Related Terms
Derivative
A financial instrument whose value is derived from the value of an underlying asset, index, or rate.
Swap
A derivative contract through which two parties exchange financial instruments, often involving cash flows based on a notional principal amount.
Credit Risk
The risk of loss due to a debtor’s non-payment of a loan or other line of credit.
Speculation
The act of trading in an asset or conducting a transaction with the expectation of significant returns, often involving high risk.
Online References
- Investopedia: Credit Default Swap (CDS)
- Wikipedia: Credit Default Swap
- U.S. Securities and Exchange Commission (SEC): Credit Default Swaps
Suggested Books for Further Studies
- “Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments” by George Chacko, Andrew W. Lo, Tomaso Poggio, and Roy Z. Shankar.
- “Credit Derivatives: Trading, Investing and Risk Management” by Geoff Chaplin.
- “Credit Risk Modeling using Excel and VBA” by Gunter Löeffler and Peter N. Posch.
- “The Handbook of Credit Derivatives” edited by Janet M. Tavakoli.
Fundamentals of Credit Default Swap: Finance Basics Quiz
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